Using Base Metals As An Economic Indicator

Gold has been the stock market's darling for quite sometime now. Investors watch gold's movement with bated breath to assess the possibility of future inflation and weakness in global economies. While investors can learn a lot by watching the performance of precious metals, they should not overlook what can be learned by watching the price movements in base metals.

The performance of base metals is an excellent way to gauge economic activity around the world. While precious metals are stored up and held for investment, base metals bear watching because these are the actual inputs used in manufacturing, construction and production. Companies cannot build their products or expand their facilities without relying on these natural resources.

Types of Base MetalsSo, what is a base metal anyway? Base metals are common metals that can typically be found in plentiful supply. Copper, zinc, aluminum, steel, tin and lead are examples of some of the more popular types of base metals. Since base metals are more readily available, they often do not have the hefty prices of precious metals. For example, while gold traded at a whopping $1,400 an ounce in 2010, copper traded for just $4 a pound. That's a pretty drastic difference!

The base metals have a variety of applications in almost every industry. Steel is used for building houses, automobiles, plants, factories and equipment. Copper is used for just about anything including wires, pipes, construction projects, heating and cooling systems. Zinc is used to produce batteries, fuel cells, die castings and making brass. Aluminum is useful in creating planes, cans, utensils, brakes and transmission lines. Tin is used to coat a number of products, including cans, containers and packages. Lead is used in construction projects and batteries. These are just a few of the uses for these well-known base metals - there are thousands more. (For more, check out The Copper King: An Empire Built On Manipulation.)

Base Metals and Price MovementMetal prices are largely controlled by consumer demand for the products that they are inputs for. Take the price of steel as an example. Hot-rolled coiled steel peaked before the financial crisis of 2008, reaching its apex in 2004 when global economies were booming. New buildings, cars and many other products were driving up the price up until 2004, and then demand leveled off or began to decline slowly. Steel fell off of a cliff in early 2009, as demand for the products and the metal itself waned. Iron ore, copper and aluminum took similar plunges in the face of dropping production and, therefore, dropping demand. The flat-lined or declining steel prices from 2004 to 2009, when prices plummeted, can now be interpreted as an early sign of economic problems to come.

Not everyone was selling out at the low, however. China went on a metals buying spree in 2009 and 2010, and the metals market surged once again. China stockpiled steel, iron ore and copper while prices were low because they knew that a base-metals rebound was coming. The country's government predicted the trend correctly and base metals recovered nicely. The steel industry saw hot-rolled coil prices surge to $700 during the global recovery of early 2010. Prices pulled back somewhat during the summer of 2010 as stimulus packages stopped – slowing government funded construction projects - and global economies also slowed down. The lead time on base metal prices as an indicator can be short, but there is a pattern that has held up in modern times. (Find out how to buy in to this emerging economy in Investing In China.)

Base Metals and Global EconomiesInvestors who want to know where global economies are headed should keep an eye on base metals. Base metals are a great precursor for signaling economic growth. They are used by many professional traders as a leading economic indicator. Famed trader Dennis Gartman has been known to watch copper, steel and aluminum indexes to judge the appetite of consumers around the world. Gartman stated that many base metals "moved downwards long before the data signaled weakness in the global economy." (To learn more, check out Leading Economic Indicators Predict Market Trends.)

Base Metals and DemandThe demand for base metals during times of economic uncertainty can tell you a lot about the economy as a whole. High demand during tough economic times shows that both business and consumer confidence remains high. Low demand leads to falling prices and is a sign of fear in the marketplace. Investor appetite for these hard metals decreases during economic slowdowns, just as it does for producers. However, this decline has a limit, as dwindling supplies and/or shortage fears, however temporary, help to buoy the prices of base metals as stockpiling drives up demand.

Base metal production and demand nearly have a perfectly symmetrical relationship. As demand for base metals increases, metal producers ratchet up production. Consequently, the flood of supply on the open market eventually leads to a decline in metals prices as supply outpaces demand. Metals prices reach their highest point when three factors align to distort the balance between supply and demand. This is when the supplies of metals are tight, demand is strong and production is already at or near full capacity. (For more, see our Economics Tutorial: Supply & Demand.)

Other FactorsAs with any other asset, base metal prices can also rise and fall on speculation by investors and traders. For example, the mere hint that a major investor like Jim Rogers is buying metals can move the whole market on a given day. Moreover, reports about the Federal Reserve easing monetary policy often drives up metal prices, as the issuance of more governmental debt strengthens the demand for precious and base metals because of their perceived hedge against inflation. Currency moves also affect the metals market. A weak dollar or Japanese yen can send investors running for the safety of hard assets just like inflation fears do. As a result, using base metal prices as an economic indicator requires that an investor look at who is driving the demand. Is it the producers using the metals to make more products or is it investors looking to escape inflation or weak currencies?

Bottom LineAs you can clearly see, base metals are a major factor in driving economic growth, but their message to investors can be hard to read. These metals are used for building homes, automobiles, plants, equipment, pipes, wires and just about any other product that you can find. If you want to know which way the economy is moving, looking at the trend in base metal prices is a good place to start.